Finding portfolio protection from U.S. default in options

Markets have seen increased volatility since Congress failed to come to a budget deal and forced the U.S. government to shutdown. As the shutdown drags on, equity markets have fallen as the Oct. 17 deadline quickly approaches. Should Congress fail to act by then, the U.S. government will risk defaulting on their obligations and the possibility of another great recession. The uncertainty surrounding these risks has caused markets to tumble as nervous investors sell stocks ahead of a possible default.

With the deadline drawing nearer many traders are asking themselves how they can protect their long equity positions in the event a deal is not reached in time. A trader has many options available. They can short index futures, buy puts on index ETFs, or use options on futures to buy downside protection. While all of these products offer viable hedges, the ability of options on futures to set up a low premium hedge is unparalleled. Options on E-mini S&P 500 futures will offer the cleanest and most cost effective hedge.

Using options we can calculate an implied downside move ahead of an event such as the debt-ceiling deadline. Looking at E-mini S&P 500 future options on the Nov. 8 expiration, we see that the market is implying a move of around 57.00 points. We calculate this by using the price of the at-the-money straddle. Using this implied move we can calculate a downside target of 1603.00 by expiration and then use that level to set up our trade.

This trade is a low cost way to protect against potential losses in a long equity portfolio. This trade is established for a relatively small amount of premium and offers a trader a very efficient and cost effective hedge.

About the Author

James Ramelli is the Moderator of the Live Futures Options Trading Room at KeeneOnTheMarket.com where he actively trades futures and options on futures while educating members on strategies, setups and risk management. He has a degree in Finance with a focus in Derivatives Trading and Financial Engineering from The University of Illinois and has been trading for five years. James appears regularly on Bloomberg T.V. and BNN and writes a weekly column for Futures Magazine.